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Navigating the Investment Minefield

July 10, 2017 • FINANCE & BANKING, Global Capital Markets, Responsible Finance

By H. Kent Baker and Vesa Puttonen

Fraudsters are always on the look out for prey – investors they can manipulate and take advantage of. The authors discuss 8 traps you should look out for in navigating through the investment minefield. After all, vulnerability, if not gullibility, and can be costly.

 

The investment world can be a scary place, especially given that some people want to take advantage of you by setting investment traps. A trap is something that can lead to losses of capital or opportunities to make productive investments. Given that many investment traps are difficult to detect, what chance do investors have navigating the investment minefield and emerging unscathed? The answer is not much unless they become aware of the traps that are strewn along their path and sidestep them. Although succumbing to such traps is unlikely to be fatal, it can seriously harm personal wealth, affect achieving financial goals, and damage self-esteem. Our purpose is to expose eight common investment traps so that you can avoid falling victim to them.

 

Trap 1. Becoming a Victim of Investment Fraud and Other Scams

Have you ever been a victim of investment fraud? If not, you probably know someone who has. The countless number of investment frauds, scams, cons, schemes, and swindles demonstrates how easily skilled fraudsters can dupe unsuspecting investors. In his book Swindling Billions: An Extraordinary History of the Great Money Fraudsters, Kari Nars estimates that fraud victims around the world have lost hundreds of billions of dollars in the last decade to investment fraud.1 Anyone with money is at risk of investment fraud. Even highly successful, financially intelligent people can fall prey to investment fraud. For example, Bernie Madoff’s infamous Ponzi scheme fooled thousands of individuals, including celebrities, as well as financial institutions and universities. A Ponzi scheme is a form of investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.

People also have a psychological need to feel special. Fraudsters play upon this need by convincing them that they are part of an “exclusive club” and are being given special access to an investment opportunity.

Investors fall for scams for many reasons. Some people are gullible so fraudsters prey on their trusting nature. Other investors are irrational and driven by emotion, which makes them particularly susceptible to becoming victims of investment fraud. Because investors are attracted to financial gain, the lure of “get-rich-quick” schemes flames their innate desire to become financially better off. In an uncertain financial environment, investors often turn to others who appear or proclaim to be experts only to have these people take advantage of them. On other occasions, investors can be overly optimistic, which makes them more likely to be hoodwinked than others. People also have a psychological need to feel special. Fraudsters play upon this need by convincing them that they are part of an “exclusive club” and are being given special access to an investment opportunity. Finally, investors are more vulnerable when they believe they are knowledgeable. Although this sounds counterintuitive, those who have some experience in investing or believe they are experts are more susceptible to investment fraud than others. Such investors think they know more than they actually do or that they are too smart to fall for a scam.

To avoid being scammed, you should be aware of several major warning signs. One common warning sign is someone touting an investment with high guaranteed returns with little or no risk. Claims of huge gains with almost no risk are illusions or “phantom riches” for unsuspecting investors. All investments carry some degree of risk. Fraudsters dangle the prospects of easy money to entice you to buy. Investments that seem too good to be true probably are. Another red flag is an investment hyped as a “once-in-a-lifetime deal”. You should also be suspicious of claims that “everyone is buying” and resist pressure to buy quickly. No reputable investment professional should push you to make a quick decision. Although not applicable to all investments, you should be suspicious of investments, such as common stocks or equity mutual funds, providing consistently stable returns regardless of market conditions. Returns generally vary over time due to market volatility. A final warning sign concerns investments or strategies that are overly complex. If you don’t clearly understand the investment, walk or better run away.

 
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About the Authors

H. Kent Baker, CFA, CMA is University Professor of Finance at American University’s Kogod School of Business in Washington, DC. He is the author or editor of 28 books and more than 165 refereed journal articles. The Journal of Finance Literature recognised him as among the top 1 percent of the most prolific authors in finance during the past 50 years. Professor Baker has consulting and training experience with more than 100 organisations. He has received many research, teaching and service awards including Teacher/Scholar of the Year at American University.

Vesa Puttonen is Professor of Finance at Aalto University School of Business in Helsinki.  He has published 16 books and more than 30 journal articles on different aspects of Strategic Finance, Risk Management, Behavioural Finance, and Investing. Professor Puttonen has worked as Senior Vice President at the Helsinki Stock Exchange and as Managing Director at Conventum Asset Management (Helsinki). He is a faculty member of MBA Programs in Helsinki, Hong Kong, Singapore, Poland, China, Iran, Taiwan, and South Korea.

References

1. Kari Nars. 2009. Swindling Billions: An Extraordinary History of the Great Money Fraudsters. London: Marshall Cavendish Business.
2. Jay R. Ritter. 2012. “Is Economic Growth Good for Investors?” Journal of Applied Corporate Finance 24 (3), 8 – 18.
3. Jonathan J. Koehler and Molly Mercer. 2009. “Selection Neglect in Mutual Fund Advertisements.” Management Science 55 (7), 1107-1121. Congsheng Wu. 2009. “Mutual Fund Advertisements.” Investment Management and Financial Innovations 6 (2), 68 – 76.
4. Matthew R. Morey. 2016. “Predicting Mutual Fund Performance.” In H. Kent Baker, Greg Filbeck, and Halil Kiymaz (eds.), Mutual Funds and Exchange-Traded Funds – Building Blocks for Investment Portfolios, 349 -363. Hoboken, NJ: John Wiley & Sons, Inc.
5. Lubos Pastor, Robert F. Stambaugh, and Lucian A. Taylor. 2014. “Scale and Skill of Active Management.” NBER Working Paper No. 19891. February.
6. Antti Petajisto. 2013. “Active Share and Mutual Fund Performance.” Financial Analysts Journal 69 (4), 73 – 93.
7. Brad Barber and Terrence Odean. 2000. “Too Many Cooks Spoil the Profits: Investment Club Performance.” Financial Analysts Journal 56 (1), 17 – 25.

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